Can the Fed Deliver?

All eyes are on the Fed today as it concludes its two-day meeting and releases its statement in the afternoon. The expectation is for the central bank to come out with some market-friendly measure, with ‘Operation Twist’ as the most likely outcome. Yields on longer-dated treasury bonds have been under pressure lately partly in response to this growing ‘Operation Twist’ chatter. The risk at this stage appears to be if the Fed fails to meet this growing clamor to do something.

There are no distracting headlines from the European side as the Greeks are reportedly making progress in their negotiations with creditors. If Greece is seen to be coming through on its existing commitments to make budgetary cuts, then it will get the next tranche of bailout money next month. The market believes that the Greeks will run out of cash by the middle of next month if they fail to get the money.

But rest assured that this story is not going away anytime soon even if the current impasse gets resolved. For today at least, we don’t have to worry about that story and just stay focused on the Fed meeting.

The economic impact of replacing short-term treasury bonds with longer-dated instruments on the Fed’s balance sheet, which is the essence of ‘Operation Twist,’ is far from clear. The market has likely priced-in the move already, as the recent downtrend in the 10-year treasury yields shows.

There are also questions about the overall size of purchases as a result of the program. I have seen estimates that the Fed balance sheet will likely experience short-term maturities of about $150 billion over the coming year. Relative to the size of the treasury market and the Fed balance sheet, purchases on that scale may not amount to much of a ‘twist.’

The major risk at this stage is the Fed’s inability to come through on this market expectation. We know that three regional Fed governors dissented with the decision to spell out the duration of the near-zero interest rate in the last FOMC meeting. With headline inflation readings running high and the effectiveness of further easing measures far from certain, Fed Chair Bernanke may find it difficult to create consensus within the committee.

But on the flip side, ‘Operation Twist’ may not arouse as much opposition from the dissenters as it does not involve any expansion of the Fed balance sheet. As such, even inflation hawks will find it difficult to oppose it purely on price-stability grounds.

In corporate news, Adobe’s (ADBE) weak quarterly results this morning were more than offset by positive guidance for the fourth quarter. We also got a modest earnings beat from Oracle (ORCL) on inline revenue. The company continues to struggle with the hardware side of its business, but the strength on the software side appears to be more than making up for that softness.

We also have a dividend-hike announcement from Microsoft (MSFT). Mr. Softee is raising its quarterly dividend by 25%, the largest increase since it started paying dividend almost seven years ago.

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